May 6, 2009

Nudge-ocracy

Barack Obama has the type of mind--orderly, analytical, well-read--that takes naturally to the study of ideas. But he's always been uncomfortable describing himself in ideological terms. Is he a liberal? During the campaign, Obama would mock those who applied the label to him: "There's nothing liberal about wanting to reduce money in politics," he'd say. "There's nothing liberal about wanting to make sure [our soldiers] are treated properly when they come home." Is he a moderate? Certainly not when others have suggested it: He once asked the Democratic Leadership Council to remove him from its list of rising stars.

But, when you look at the sum of Obama's early policies, you begin to see the contours of a distinctive philosophy. Unlike the Progressives or the early New Dealers, Obama has no intention of changing the nature of American capitalism. Not through old-fashioned Jeffersonian means (antitrust) or newer-fangled Hamiltonian techniques (industrial planning). His program doesn't set out to reinvent whole sectors of the economy, not even our broken banking system. And, unlike postwar liberals, he has no zeal for ramping up the regulatory state, aside from tightening the screws on financial services. But, even then, he's resisted key parts of Europe's proposal for greater controls on hedge funds.

Like the New Democrats who ultimately shaped the Clinton administration's agenda, Obama has a deep respect for the market and wants to minimize the state's footprint on it. He has little interest in fixing prices or rationing goods or reversing free-trade agreements. But, while he basically shares the New Democrats' instincts, he rejects their conclusions. Reacting against the overweening statism of their liberal ancestors, many New Democrats came to believe that if government largely got out of the way and let markets work properly, the natural result would be widely shared prosperity. You only need to view the extent of Obama's domestic agenda to know he doesn't agree.

Instead, Obama has set out to synthesize the New Democratic faith in the utility of markets with the Old Democratic emphasis on reducing inequality. In Obama's state, government never supplants the market or stifles its inner workings--the old forms of statism that didn't wash economically, and certainly not politically. But government does aggressively prod markets--by planting incentives, by stirring new competition--to achieve the results he prefers. With health care, for instance, he would make it easier for employees to tote their insurance from job to job, eliminating the disincentive for insurers to invest in preventive care. Or take his bank plan, which helps banks dispose of their toxic assets, reducing uncertainty and making the banks more attractive to private investors--a far less drastic step than nationalization. Rather than force markets to conform to his wishes, he shapes their calculus so they conclude (on their own) that their interests coincide with his wishes.

Obama is hardly the first president to grasp the appeal of manipulating incentives and altering the context in which we make decisions. In the mid-'70s, Charles Schultze, Jimmy Carter's top White House economic adviser, sketched out a version of the conceit in a book called The Public Use of Private Interest. Schultze favored "harnessing the 'base' motive of material self-interest to promote the common good"--say, by taxing rather than outlawing harmful activities. A generation later, the behavioral theorists Richard Thaler and Cass Sunstein, both informal advisers to the Obama campaign, hatched a descendant of this approach. In their own book, Thaler and Sunstein suggested that the government inculcate desirable habits like saving and philanthropy through a series of gentle "nudges."

Given the alternatives--even greater federal involvement, even more federal dollars--such "harnessing" and "nudging" makes enormous political sense. But Obama's version also represents a huge gamble. Many countries have nationalized banks and run health care systems--and we have, at least, a good sense of how those programs would turn out. The Obama approach is largely untested on the scale he proposes, which is far greater than anything Schultze or Thaler and Sunstein imagined. His plans can be dismayingly complex; they often involve heroic assumptions about how people respond to new incentives. There's more than a hint of Ira Magaziner--the much-derided architect of Bill Clinton's 1993 health care plan. But, if it works, Obama will have truly found the Third Way Clinton grasped for a decade ago.

By 1976, Schultze could no longer contain his frustration with the inefficient "command-and-control"-style regulations Democrats had embraced for a decade. He laid out an alternative vision in a series of lectures on the eve of the Carter administration. Under the prevailing approach to worker safety, for example, bureaucrats would hit employers with an endless list of dos and don'ts. "If specific regulations are the only bar to prevent social damages," Schultze wrote, "first it will take 21 pages to deal with ladders, and then even more as time goes on." Schultze advocated a far more elegant alternative: worker-injury taxes and steep workers' comp payouts. By making injuries costly to employers, the government could improve safety without peering onto every factory floor in America.

Schultze helped sell Carter on deregulation, which he brought to the airline and trucking industries. And, though Schultze's broader agenda died with Carter's failed presidency, his ideas lived on in the minds of liberal technocrats like Gary Hart and Michael Dukakis. Then, in 1992, Bill Clinton discovered them through the work of an influential policy guru named David Osborne. Osborne's big idea was "reinventing government" to make it more efficient, more responsive, and altogether more businesslike. In the process, he advocated certain reforms--like public-school choice, tenant ownership of public housing, competition between government and the private sector--that would achieve desired outcomes with a lighter bureaucratic touch. The government should "steer, not row," Osborne proclaimed.

At the time, Clinton was running on a two-pronged strategy of harnessing populist resentments while also redeeming the Democratic Party from its Great Society overreach. Toaccomplish the first goal, Clinton called for strict limits on executive pay and investments in worker retraining. When it came to the second, the Schultze-Osborne model held considerable appeal, and Clinton leaned on it heavily. In response to George H.W. Bush's charge that he was pushing warmed-over tax-and-spend liberalism, Clinton took a page (almost literally) from Osborne's book, telling an audience at the University of Connecticut he wanted to run "a government that steers more than it rows; a government that is a catalyst for action by others; a government that is market-oriented, less bureaucratic, and more entrepreneurial."

After Clinton won, both liberal populists and Osborne-like moderates had reason to believe he would stand with them. Which might have been possible in less constrained times. But the deficits of the early '90s threw the two wings of the party into direct competition. During the transition, Clinton's economic advisers concluded that, if the fiscal status quo persisted, the red ink would top $350 billion by 1997. It sounds almost quaint in our current era of trillion-dollar deficits. But, at the time, the anxiety was palpable. Long-term interest rates had jumped in the fall, and inflation fears were pervasive. Clinton's incoming chairman of the Council of Economic Advisers, Laura Tyson, warned of a "long-term risk of financial collapse," according to Bob Woodward's The Agenda.

Clinton, like Obama, had spent the transition hashing out his budget priorities and the shape of a stimulus for a recession-weakened economy. He eventually made the exact opposite choices his Democratic successor would, scaling back his beloved middle-class tax cut and domestic spending plans in favor of deficit reduction. The theory behind this decision came straight from Fed chairman Alan Greenspan, vouched for by Clinton's then-economic aide Robert Rubin: The bond market would bid down long-term interest rates in anticipation of lower deficits, which would eventually spur economic growth. Shrinking the deficit would also free up capital for private investment. Still, the move was likely to inflict pain early on, and the realization set Clinton brooding. When Al Gore urged him to be bold like Roosevelt in the 1930s, Clinton snapped: "Roosevelt was trying to help people. Here we help the bond market and we hurt the people who voted us in."

And yet, somehow, Clinton managed to satisfy both--and far sooner than his advisors anticipated. Before long, the economy was creating jobs at a dizzying clip--ten million between 1993 and 1997, another eight million between 1997 and 2000. Rising productivity was driving up wages across the income spectrum. By some measures, poverty was the lowest since the government had begun keeping track. It really did look like shrinking deficits had triggered lower interest rates and unleashed a wave of private investment that was powering the economy to new heights.

It's what came next that darkens the narrative. Amid all the new economy triumphalism, the Clintonites deregulated the telecommunications industry and repealed New Deal-era restrictions on bank consolidation. In 1997, Clinton even signed a bill lowering the capital-gains tax rate, that perennial GOP fetish. Having begun their administration grudgingly appeasing Greenspan, the Clintonites gradually embraced his view that, in many cases, government could do no better than step aside.

In recent months, several of the architects of Clintonomics--Larry Summers, Gene Sperling, Rahm Emanuel--have reassembled to take another crack at creating broad-based prosperity. What's striking is the change in their thinking about how to pull it off.

In fact, the center-left had revised its economic theories while the bubble was still inflating. Beginning in 2004, the data gradually began to undermine the Clintonites' central assumption: that the benefits of growth would accrue to the poor and middle class. Their policies, it turns out, had only temporarily tamped down the income inequality that had been rising since the 1970s. Workers' wages had once tracked productivity growth. Now workers were producing more, but only the wealthy were reaping the rewards; everyone else's income had basically flattened out. The economists Robert Gordon and Ian Dew-Becker, both then at Northwestern, put into words what much of their profession was thinking. "A basic tenet of economic science is that productivity growth is the source of growth in real income per capita," they wrote in 2005. "But our results raise doubts, that we find surprising and even shocking, about the validity of that ancient economic paradigm." Worse still, it was tough to pin these findings on George W. Bush. Although his tax cuts had undoubtedly exacerbated the trend, they couldn't account for what was happening to pre-tax income.

Suddenly the '90s were looking less and less like the dawn of a new economic model and more like a historic anomaly fueled by a once-in-a-lifetime technology boom. And what remained when the boom subsided was insecurity, dislocation, and stagnating standards of living. Globalization was especially bracing. The Clintonites had believed strongly in greasing the flow of goods and capital across borders. Now they wondered if they'd oversold the benefits and understated the costs. Alan Blinder, a former Fed Vice Chairman and White House economic adviser, published a paper warning that between 22 and 29 percent of all U.S. jobs were at risk of being "offshored."

In 2006, Rubin launched a think tank called the Hamilton Project, whose aim was to design a response to the insecurity that didn't threaten free trade and fiscal discipline. Peter Orszag, the former White House aide Rubin hired to run it, christened the approach "warm-hearted but cool-headed." In many respects, the effort represented a new consensus within the party, and the locus classicus of the kumbaya spirit was a New York Times op-ed jointly authored by Rubin and Jared Bernstein of the labor-backed Economic Policy Institute. The two men professed their shared desire to see a revived labor moment, one of the few forces they could imagine restoring workers' bargaining power.

During his campaign for the Democratic nomination, Obama sometimes seemed more interested in filleting Clintonism than signing onto the center-left truce. He famously thrashed the politics of triangulation in a Des Moines Jefferson-Jackson Dinner speech that may have saved his campaign. But, looking back over his time in the national spotlight, the periodic sops to populism stand out as the exception. In The Audacity of Hope, Obama endorsed fiscal conservatism and deferred to Rubin's instincts on trade. A dialogue between the two about the loss of jobs at an Illinois Maytag plant ends with Obama nodding in agreement: "It was hard to deny Rubin's basic insight," Obama wrote. "We can try to slow globalization, but we can't stop it."

When the Hamilton Project launched in 2006, Obama attended the group's maiden event and lavished it with praise: "some of the most innovative, thoughtful policy-makers ... the sort of breath of fresh air that I think this town needs." He affirmed this conclusion after winning the election, stocking his administration with the think tank's highest-profile contributors.

He was going to need them. The problem with Clintonism was that it had partly sacrificed the goals of 1960s- and '70s-style liberalism even though it had only meant to exorcise the bogeymen. Hence Obama's challenge: to reclaim progressive goals without the economic self-sabotage of the earlier era.

There are no grand theorists in the Obama orbit, certainly no in-house ideologists. During the campaign, Obama sold himself as a green-eyeshade pragmatist, insisting every one of his proposals was "paid for." But, in fact, there is, if not an ideology, then certainly a sensibility that reigns in Obamaland.

Perhaps the easiest place to see it is in the administration's fondness for behavioral economics, the branch of the dismal science that recognizes that humans aren't utility-maximizing automatons, but flawed creatures who often screw up simple calculations and struggle with self-control. The key behavioral insight is that the way we frame choices matters enormously. Take a classic behavioral example: pensions. In a fully rational world, everyone would enroll in their company's 401(k), which provides a financial incentive to save for retirement. In the real world, we frequently put off enrollment, not wanting to weigh all the confusing options or fill out tedious paperwork. If, on the other hand, our employer enrolled us automatically but allowed us to opt out, most would stick with it. Simply by changing the "default" option from out to in, we improve workers' welfare without limiting their freedom.

Thaler and Sunstein have dubbed this policymaking approach "libertarian paternalism," and it was highly influential within the campaign. (Sunstein, a longtime contributor to The New Republic, is now a top official in Obama's Office of Management and Budget.) For example, in addition to the retirement saving reform, which Obama later wrote into his budget, the campaign also warmed to a proposal called "intelligent assignment." The idea was a response to the fact that seniors enrolled in the Medicare prescription drug program are often overwhelmed by the dozens of plans they have to choose from, sometimes to the point of paralysis. The Obama wonks favored automatically enrolling many of them in the plan that best suited their needs, based on their drug-buying histories, then allowing them to switch if they found one they liked better.

In the grand scheme of things, these "nudges" were minor tweaks designed to elicit more rational behavior. But, in many respects, what the Obama administration has done these last few months is simply scale up the logic of nudging, albeit massively. Not all of Obama's nudges fall out of behavioral economics, per se. Some involve changing incentives to encourage certain activities and discourage others. Some involve fostering competition to trigger innovation. But, as in the behavioral examples, the Obamanauts typically have an outcome they want to promote. And, like the behaviorists, they instinctively recoil from imposing it unilaterally. So, instead, they monkey around with the choices people face, seeking to influence decision-making rather than mandate decisions.

Nowhere has this approach been more visible than the administration's response to the financial crisis. When it comes to the banks, many liberal economists favor seizing insolvent institutions, stripping out their toxic assets, restocking their supply of capital, and then selling them off to new owners. But the prospect of something so heavy-handed offends the administration's sensibilities. Instead, Treasury has chosen to partner with hedge funds and private equity firms to relieve the banks of their toxic assets. The thinking is that bad assets create uncertainty, which repels investors and makes it tough to raise money in the financial markets. By moving the toxic assets off their books, Treasury hopes to make the banks more attractive to investors and, therefore, less likely to need public money.

Or take Obama's housing plan, which gives lenders financial incentives to lower monthly payments for borrowers at risk of default. If Obama wanted to intervene directly, he could dispatch government officials to rewrite mortgages. But this is unnecessary--it's actually in the buyers' and the lenders' interest to agree on new terms because the alternative, foreclosure, is so costly to both. The reason it doesn't happen already is that the original lender is the one who decides whether to modify a loan, even though it typically has long since sold the loan off in pieces to investors. The point of the subsidies is to focus the loan originator's mind--to provide an incentive to do what's in the interest of both borrowers and investors.

The idea of nudging actors in the right direction also animates the administration's solutions to our most pressing social problems. For instance, the biggest reason people overconsume fossil fuels is that the prices they pay for oil, gas, and coal don't reflect their true social costs, which include the toll they inflict on the environment. A cap-and-trade system, by limiting overall carbon emissions (as opposed to emissions for any given company) and charging energy producers for the right to pollute, raises prices and forces consumers to weigh the true cost of their activities. This should not only reduce consumption of fossil fuels, it should make alternative energy more competitive and spur investment in green technologies.

As it happens, Schultze was an early proponent of reducing pollution by pricing harmful emissions. (He preferred an emissions tax, which is analytically similar to cap-and-trade.) Schultze saw this as far more efficient than mandating cleaner technologies, such as the catalytic converters Washington had forced carmakers to install. The difference is that Schultze and Osborne--and their political patrons, Carter and Clinton--were trying to scale back an overgrown government and its bloated bureaucracy without abandoning their liberal goals. Obama, by contrast, seeks to expand the reach of the state after a generation of retreat. That his approach to this avoids heavy-handed market interventions shouldn't disguise his ambitions.

The administration's health care approach nicely illustrates this mentality. To take one example, the United States has underinvested in preventive medicine for years. Even though such care could save hundreds of billions of dollars in expensive treatments and lost productivity, insurers have little financial incentive to subsidize it because Americans frequently change plans when they switch jobs. The benefits would accrue to another insurer.

One way to fix this would be to make it easier for patients to keep the same coverage as they move from job to job, giving the insurer an incentive to subsidizepreventive treatment like regular checkups and cancer screenings. The health care plan Obama talked up on the campaign trail, like many of the Democratic plans currently moving through Congress, does precisely that. (The administration has yet to spell out health care details, but Obama's top wonks are known to favor these innovations, Orszag in particular.)

Another goal is to improve the quality of the health care we receive through competition--as with a so-called "public option," in which government insurance competes with private plans. (In principal, between one-third and one-half of workers could be eligible for the public plan, though the actual number will likely be smaller.) For example, medical research increasingly shows that coordinating treatment--say, having an internist partner with a cardiologist to treat a heart patient--yields better results than when doctors work in isolation. But most private insurers have little incentive to insist on cooperation because quality improvements don't currently affect their bottom line. Competition could change that. If the government improved quality--say, by changing the way it reimburses doctors to induce cooperation--then private insurers would have to either follow suit or lose business.

It's a model that's worked in education. The economist Caroline Hoxby has found that competition from private schools and charter schools tends to improve performance at traditional public schools, which risk losing students if their test scores and graduation rates don't keep pace. Charter schools are also an element of the Obama agenda.

The Obama approach can even work by removing obstacles to behavior we'd like to promote. In a 2003 book called The New Financial Order, which Obama's wonks read Talmudically, Yale economist Robert Shiller suggested that workers were skimping on productivity-enhancing skills because technology and globalization had made such training risky. When a factory job can be outsourced seamlessly, or when an entire domestic industry can disappear within months, acquiring new skills can seem pointless.

Several of Obama's top economic advisers--Summers, his deputy Jason Furman, Orszag, and Sperling--have embraced one of Shiller's central proposals for reducing this disincentive: wage-loss insurance. The idea is that the government would offset the pay cut a worker might take after losing a job in an industry hit hard by global competition or technological change. The factory worker forced to retreat behind a Gap sales counter would no longer see his income fall through the floor, making the training a less risky bet.

The thread that runs through these proposals is a hands-off approach to markets themselves, but a hands-on approach to the incentives and defaults that influence decisions. Obama only broaches direct intervention when he can't elicit the desired outcome through such rejiggering--as with the numerous investments the market won't finance because it can't capture the returns. Consider the scholarly consensus that every dollar of preschool spending on disadvantaged children produces enormous social returns--increasing future productivity and decreasing tendencies toward criminal activity and unplanned parenthood. Alas, there's no way for a private investor to pocket those savings. That's why Obama's stimulus allocated $2 billion to Head Start and Early Head Start. For similar reasons, Obama spent significant sums on high-speed rail, National Science Foundation research grants, and rural broadband access.

As a theory of government, this approach has much to recommend it. It's resolutely liberal in its ends, ambitious in its means, but also respectful of individual freedom. It is, in other words, a government that is activist but distinctly not socialist.

If anything, the lengths to which Obama goes to avoid impinging on the market are almost too great. In the case of the banks, temporary nationalization might be the simplest, most direct approach. By contrast, the Geithner plan, with its Public-Private Investment Program, seems to rely on a set of elaborate assumptions about bank and investor behavior. It presumes banks are willing to sell assets at a loss, that risk-shy investors will be compelled by cheap government financing, that other investors will park their capital in banks once their balance sheets are cleaner. If any of these assumptions fails, the whole effort could fall apart.

The health care plan suffers from a similar Rube Goldberg quality. For example, the "public option" sounds like an elegant way to improve quality by promoting competition. If only it were so simple. The problem is that private insurers have every opportunity to game the system: By skimming off the youngest, healthiest patients and leaving the rest for the government to cover, they drive down their own costs and make the public option look outrageously expensive by comparison. To prevent this, the government would have to restrict the way private insurers woo patients--something that's not impossible, but definitely tricky, given the variety of subtle techniques for screening out the sick. At a certain point, it seems far less complicated to just expand Medicare to everyone. The irony here is hard to miss: In order to keep its hands mostly off the free market, the Obama administration sometimes has to hatch schemes so convoluted they'd make an ambitious social planner blush.

Which raises a final objection: What's so great about private insurers or the people who currently run our banks? We are, after all, talking about a banking industry that triggered a global financial meltdown and which, according to the IMF, may be sitting on trillions in losses to show for it. We're talking about a private health insurance industry that leaves almost one-sixth of the U.S. population without coverage and is a major reason we pay more for health care on average than any other country and get only mediocre results in return.

And yet, Obama has shown little interest in refashioning these industries. Even his proposal for reforming financial market regulation accepted the existence of banks too big to fail, relying instead on an uber-regulator to prevent any single overgrown bank from threatening the financial system. (The alternative would be to use antitrust law to break them into smaller, more manageable pieces.) In light of these industries' track records, Obama's solicitousness might seem puzzling.

Except that it may well work. Private investors do part with their money when uncertainty subsides; competition does tend to improve quality; markets do have a knack for allocating resources, at least when incentives are correctly aligned and the relevant costs are priced in.

Sure, the Obama program makes some big assumptions. Yes, there may be more direct routes to universal health care or a solvent banking system. On the other hand, it's easy to underestimate the challenges of the more statist alternatives. Bank nationalization, for one, is fraught with pitfalls. Anyone who thinks the government would be an efficient manager of large commercial banks clearly wasn't paying attention during the AIG bonus uproar--which, however justified, showed that political realities can trump economic imperatives in a government-run enterprise. In any case, it may be possible to graduate to the more ambitious course if the moderate one fails; it's not obvious that the reverse is true. By first trying to fix the banks with a lighter touch, Obama may strengthen his hand for nationalization if circumstances demand it.

The political point is, in the end, difficult to overstate. Obama has groped toward a form of liberal activism that is eminently saleable in this country--both with the average voter, easily spooked by charges of creeping statism, and the constellation of political interests in Washington. Any economic program that lays out ambitious goals and actually has a chance of achieving them would have much to recommend it on those grounds alone. Better still, it may be the bold, persistent experimentation that the moment demands.

Franklin Foer is the editor of The New Republic. Noam Scheiber is a senior editor at The New Republic.